TEKNOIOT: Financial Reform
Showing posts with label Financial Reform. Show all posts
Showing posts with label Financial Reform. Show all posts

22 Aug 2020

Fed Nixes Narrow Bank - Barokong

A narrow bank would be a great thing. A narrow bank takes deposits, and invests 100% of the money in interest-paying reserves at the Fed. (The Fed, in turn, mostly invests in US treasuries and agency securities.)

A narrow bank cannot fail*. It cannot lose money on its assets. A narrow bank cannot suffer a run. If people want their money back, they can all have it, instantly. A narrow bank needs essentially no asset risk regulation, stress tests, or anything else.

A narrow bank fills an important niche. Individuals can have federally insured bank accounts which are (mostly) safe. But large businesses need to handle cash way above the limits of deposit insurance. For that reason, they invest in repurchase agreements, short-term commercial paper, and all the other forms of short term debt that blew up in the 2008 financial crisis. These are safer than bank accounts, but, as we saw, not completely safe. A narrow bank is completely safe. And with the option of a narrow bank, the only reason for companies to invest in these other arrangements is to try to harvest a little more interest. Regulators can feel a lot more confident shutting down run-prone alternatives if a narrow bank is widely available.

The most common objection to equity-financed banking is that people and businesses need deposits. Well, narrow banks provide those deposits, and can do so in nearly unlimited amount. Narrow banking, providing completely safe deposits, opens the door to equity-financed banking, which can invest in risky assets and also be immune from financial crises.

Why not just start a a money market fund that invests in treasuries? Since deposit -> narrow bank -> Fed -> Treasuries, why not just deposit -> money market fund -> treasuries, and cut out the middle person? Well, a narrow bank is really a bank. A money market fund cannot access the full range of financial services that a bank can offer. If you're a business and you want to wire money to Germany this afternoon, you need a bank.

Suppose someone started a narrow bank. How would the Fed react? You would think they would welcome it with open arms. Not so.

TNB, for "The Narrow Bank" just tried, and the Fed is resisting in every possible way. TNB just filed a complaint against the New York Fed in District Court, which makes great reading. (The complaint is publicly available here, but behind a paywall, so I posted it on my webpage here.) Excerpts:

2. “TNB” stands for “the narrow bank”, and its business model is indeed narrow. TNB’s sole business will be to accept deposits only from the most financially secure institutions, and to place those deposits into TNB’s Master Account at the FRBNY, thus permitting depositors to earn higher rates of interest than are currently available to nonfinancial companies and consumers for such a safe, liquid form of deposit.
3. TNB’s board of directors and management have devoted more than two years and substantial resources to preparing to open their business, including undergoing a rigorous review by the State of Connecticut Department of Banking (“CTDOB”). The CTDOB has now granted TNB a temporary Certificate of Authority (“CoA”) and is fully prepared to permit TNB to operate on a permanent basis.
4. However, to carry out its business—indeed, to function at all—TNB needs access to the Federal Reserve payments system.
5. In August 2017, therefore, TNB began the routine administrative process to open a Master Account with the FRBNY. Typically, the application procedure involves completing a one-page form agreement, followed by a brief wait of no more than one week. Indeed, the form agreement itself states that “[p]rocessing may take 5-7 business days” and that the applicant should “contact the Federal Reserve Bank to confirm the date that the master account will be established.”
6. This treatment is consistent with the governing statutory framework. Concerned by preferential access to Federal Reserve services by large financial institutions, Congress passed the Depository Institutions Deregulation and Monetary Control Act of 1980 (the “Act”). Under the applicable provision of the Act, 12 U.S.C. § 248a(c)(2), all FRBNY services “shall be available” on an equal, non-discriminatory basis to any qualified depository institution that, like TNB, is in the business of receiving deposits other than trust funds.
7. TNB did not receive the standard treatment mandated by the governing law. Despite Connecticut’s approval of TNB—as TNB’s lawful chartering authority—and the language of the governing statute, the FRBNY undertook its own protracted internal review of TNB. TNB fully cooperated with that review, which ultimately concluded in TNB’s favor. At the same time, the FRBNY also apparently referred the matter to the Board of Governors of the Federal Reserve System (the “Board”) in Washington, D.C.
8. In December 2017, TNB was informed orally by an FRBNY official that approval would be forthcoming—only to be called back later by the same official and told that the Board had countermanded that direction, based on alleged “policy concerns.”
9. TNB’s principals thereafter met with staff representatives of the Board, as well as the President of the FRBNY, to explain that there was no lawful basis to reject TNB’s application for a Master Account. On information and belief, the FRBNY and its leadership agreed with TNB and were prepared to open a Master Account.
10. Though TNB had satisfactorily completed the FRBNY’s diligence review, the Board continued to thwart any action by the FRBNY to open TNB’s Master Account, reportedly at the specific direction of the Board’s Chairman.
11. Having delayed the process for nearly one year—effectively preventing TNB from doing business—the FRBNY has repeatedly refused either to permit TNB to open a Master Account or to state that the FRBNY will ultimately do so.
12. The FRBNY’s conduct is in open defiance of the statutory framework, its own prior positions, and judicial authority. See Fourth Corner Credit Union v. Fed. Reserve Bank of Kan. City, 861 F.3d 1052, 1071 (10th Cir. 2017) (“The plain text of § 248a(c)(2) indicates that nonmember depository institutions are entitled to purchase services from Federal Reserve Banks. To purchase these services, a master account is required. Thus, nonmember depository institutions . . . are entitled to master accounts.”) (Bacharach, J.) (emphasis added).
13. Further, the FRBNY’s actions, especially in the context of other recent conduct by the Board,1 have the effect of discriminating against small, innovative companies like TNB and privileging established, too-big-to-fail institutions—the very dynamic that led Congress to pass the Act in the first place.
14. TNB therefore brings this action for a prompt declaratory judgment that it is entitled to a Master Account.
Why does the Fed object?

The Fed may worry about controlling the size of its balance sheet -- how many reserves banks have at the Fed, and how many treasuries the Fed correspondingly buys. If narrow banks get really popular, the Fed might have to buy more treasuries to meet the need. Alternatively, the Fed might have to discriminate, paying narrow banks less interest than it pays "real" banks, in order to keep down the size of the narrow banking industry. It would then face hard questions about why it is discriminating and paying traditional banks more than it pays everyone else. (It's already a bit of a puzzle that it often pays interest on reserves larger than what banks can get anywhere else, even treasuries.)

But why does the size of the balance sheet matter? Why does it matter whether people hold treasuries directly, hold them via a money market fund, or hold them via a narrow bank, which holds reserves at the Fed, which holds treasuries?

"Money" is no longer money. When the Fed pays interest on huge amounts of excess reserves, the size of the balance sheet no longer matters, especially in this regard. If people want to hold more treasuries indirectly through a narrow bank and the Fed, and correspondingly less directly, why should that have any stimulative or depressing effect at all? Even if you do think QE purchases -- supply-driven changes in the balance sheet -- matter, it is not at all clear why demand-driven changes should matter.

The Fed already allows a "reverse repo program,"  in which 160 institutions such as money market funds to hold reserves. It currently pays those 20 basis points (0.2%) less than it pays banks, to discourage participation.

The second argument, made during the discussion about reverse repos, is that narrow banks are a threat to financial stability, not a guarantor of it as I have described, because people will run to narrow banks away from repo and other short term financing in times of stress.

This is, in my view, completely misguided. Again, narrow banks are just an indirect way of holding treasuries. There is nothing now stopping people from "running" to treasuries directly, which is exactly what they did in the financial crisis.

Furthermore, the Fed does not, in a crisis, seek to force people to hold illiquid assets having a run. The Fed pours liquid assets into the system like Niagara falls, and buys illiquid assets from them, all in massive quantities.

Moreover, the whole point of the narrow bank is that large businesses don't hold fragile run-prone short term assets in the first place. By paying interest on reserves, and allowing more and more people to enjoy run-proof government money, there is less gasoline in the financial system to begin with. If the Fed is worried about financial crises, it ought to encourage narrow banks and give others a gold star for using them rather than shadier short-term assets in the first place.

The emptiness of both arguments is easy to see from this: Chase and Citi are narrow banks -- married to investment banks. Both take deposits, and invest them as interest paying reserves at the Fed. Right now there are more reserves than checking accounts in the banking system as a whole. If there were some threat to monetary policy or financial stability from banks being able to take deposits and funnel them in to reserves, we'd be there now. The only difference is that if Chase and City lose money on their risky investments, they drag down depositors too and the government bails out the depositors. The narrow banks are not separated from the investment banks in bankruptcy. A true narrow bank just separates these functions.

Shadier speculations are natural as well.

Banks are making a tidy profit on their current activities. JP Morgan Chase pays me 1 basis point on my deposits, as it has forever, and now earns 1.95% on excess reserves. The "pass through" from interest earned to interest paid to depositors is very slow. This is a clear sign of lack of competition in the banking system. The Fed's reverse RP program was put in place, in part, to pressure banks to act a bit more competitively, by allowing an almost-narrow bank to take investor money and put it in reserves. The Fed is now scaling that program back.

That the Fed, which is a banker's bank, protects the profits of the big banks system against competition, would be the natural public-choice speculation.

Perhaps also my vision of a run-proof essentially unregulated banking system isn't as attractive to the Fed as it should be. If deposits are handled by narrow banks, which don't need asset risk regulation, and risky investment is handled by equity-financed banks, which don't need asset risk regulation, a lot of regulators and "macro-prudential" policy makers, who want to use regulatory tools to control the economy, are going to be out of work.

To be clear, I have no evidence for either motivation. But the facts fit, and large institutions are not always self-aware of their motivations.

Whatever the reason, it is sad to see the Fed handed such an obvious boon to financial stability and efficiency, and to slow walk it to regulatory death, despite, apparently, clear legal rights of the Narrow Bank to serve its customers.

*Well, almost. For the Fed to fail, there would have to be a large-scale US default on treasury debt. Even so, Congress could exempt the Fed by recapitalizing it, making good its losses. So Congress would have to decide that it won't even recapitalize the Fed, so that reserves also default. If there is one bank that really is too big to fail, it's the Fed, as its failure would bring down the entire monetary system. Literally, all of the ATMs and credit card machines go dark. This is a pretty improbable event.

Update: Endi below asks "Why do you say that with the existence of narrow banks, equity-financed banks would be immune from a financial crisis?" See "A Blueprint for Effective Financial Reform", "Equity-financed banking and a run-free financial system," "Toward a run-free financial system",  All here.

Update 2: Matt Levine at Bloomberg has excellent coverage. Michael Derby at WSJ too. As Matt and a commenter below explain,  I got ahead of myself on TNB. This particular company is not planning to offer banking services or retail deposits. They won't even wire money for you. The reason: if they were to do so, they would face lots of anti-money-laundering regulations. This particular business is focused on giving money market funds and other large institutions access to the 1.95% that the Fed pays on reserves, which is more than the 1.75% that money market funds can get via reverse repo at the same Fed, or (paradoxically) the rate that short term treasuries have been offering lately.

Update 3: an excellent WSJ editorial. The Fed remains silent. My forecast: The Fed will remain silent, fight the lawsuit with obfuscation and delay.  It can surely let this rot in the courts for a decade or more. By that time the TNB folks will be out of money and have to give up, and any potential copycats will get the message.

21 Aug 2020

Kotlikoff on the Big Con - Barokong

In preparing some talks on the financial crisis, 10 years later, I ran across a very nice article,The Big Con -- Reassessing the "Great" Recession and its "Fix" by Larry Kotlikoff. (Here, if the first link doesn't work.)

Larry is also the author ofJimmy Stewart is Dead – Ending the World's Ongoing Financial Plague with Limited Purpose Banking, from 2010, which along with Anat Admati and Martin Hellwig'sThe Bankers' New Clothes is one of the central works outlining the possibility of equity-financed banking and narrow deposit-taking, and how it could end financial crises forever at essentially no cost.

Larry points out that the crisis was, centrally a run. He calls it a "multiple equilibrium."  Financial institutions have promised people they can have their money back in full, at any time, but they have invested that money in illiquid and risky assets. When people all do that at the same time, the system fails. Such a run is inherently unpredictable. If you know it's happening tomorrow, you run to get your money out and it happens today.

This is a common view echoed by many others, including Ben Bernanke. What's distinctive about Larry's essay is that he pursues the logical conclusion of this view. If the crisis was, centrally, a run, all the other things that are alluded to as causes of the crisis are not really central.  Short-term debt, run-prone liabilities are gas in the basement. Just what causes the spark, how big the firehouse is, are not central, as without gas in the basement the spark would not cause a fire.

Larry puts it all together nicely by starting with the 2011 Financial Crisis Inquiry Commission report:

"There was an explosion in risky subprime lending and securitization, an unsustainable rise in housing prices, widespread reports of egregious and predatory lending practices, dramatic increases in household mortgage debt, and exponential growth in financial firms’ trading activities, unregulated derivatives, and short-term “repo” lending markets, among many other red flags. Yet there was pervasive permissiveness; little meaningful action was taken to quell the threats in a timely manner. "
Larry then takes apart each of these non-culprits, as below.

In my view, the understanding that the crisis was a run, that without a run there would have been no crisis, somewhat like the 2000 tech stock bust, and that lots and lots more capital is the only real answer, has emerged slowly over the last 10 years. Larry's essay is good for putting all the others to rest.

The insight is also optimistic. It is possible to fix one clear simple thing -- too much short-term debt, not enough capital. If all the long list of vague maladies named by the crisis commission need to be fixed by super-powerful and financially clairvoyant regulators, the job is hopeless despite the immense government expansion that would entail.

In many of these items, I think Larry oversteps a bit. The argument only needs to be that "these things might have been problems, indeed, they might have caused a recession, but without a run, induced by short-term debt, there would have been no financial crisis." Larry goes on to cast doubt whether any of them are problems at all, which is fun and provocative but more than necessary. Moreover, Larry really goes on to view recessions themselves as multiple equilibria, which is an interesting and provocative idea, but not necessary.

Larry's essay is even more to the point today. I'm at theFinancial Cycles and Regulation conference at the Bundesbank. Every paper so far takes it for granted that there is such a thing as a "financial cycle," a buildup of "excessive" or "imbalanced" debt that precedes an inevitable round of default and crisis. It is the regulator's job to manage such "debt cycles" actively. Larry's essay disagrees from the word go. It's nice to have two diametrically opposed ideas in mind.

Larry's List follows. If you get bored, skim to the bottom for his more provocative ideas on runs.

1) Liar Loans, No Doc Loans, NINJA Loans and Other Subprime Mortgages

There just weren't that many subprime defaults, especially before the crisis hit. (And, I would add, defaults not insured by fannie, freddie, etc.)

2) The “Unsustainable” Rise in Housing Prices

House prices have risen and fallen before. And, I might add, many are sustained. If you're waiting for houses in Palo Alto or Manhattan to fall to, say Joliet IL levels, you may have a long wait ahead of you.

Larry makes an interesting comparison of real house prices with real GDP,

.. real house prices can rise for years, indeed, decades. They did so essentially every year for the 32 years between Q1 1975 and Q1 2007. The rise was both smooth and gradual with real house prices only 64 percent higher in Q1 2007 than they were in Q1 1975 – this despite real GDP rising by 170 percent over the same interval.

The comparison between real house price and real GDP is unusual. Larry writes

In any case, it's not a financial crisis without short-term debt.

Certainly, a temporary drop in house prices could have produced a contraction in construction.... Moreover, a decline in a given sector doesn’t augur an economy- wide recession.

And, an important point

a drop in the price of homes does not adversely impact most homeowners. Yes, the value of their asset falls. ...

But you still get to live in the house. If you could pay the mortgage before, you still can.

if we’re talking about a nationwide decline in house prices, as we are with the GR, even those who moved experienced no economic harm because their ability to buy at a lower price offset their need to sell at a lower price.

The house price drop was great news for young people who live in apartments, as the stock price drop was great news for their retirement investment opportunities. Yes, there are theories in which the losers impact the economy asymmetrically, such as Mian and Sufi's, but we're straying away from the point here. A house price "bubble" and "burst" is not per se a reason for a financial crisis.

As in many of these "causes" it's important to distinguish events before October 2008 from those afterwards. Yes, there was a huge recession, and that caused house price declines, job losses, mortgage defaults, and so forth. But causes of the crisis have to come first.

3) Ratings Shopping

"overrating affected less than one half of one percent of the U.S. bond market. Furthermore, this small figure surely overstates the importance of ratings shopping as many of the downgrades were caused by the GR itself,"

4) Increased Bank Leverage

"Sky-high bank leverage is another part of the standard GR explanation....Bank leverage actually fell over the period 1988 through 2008.16 Equity rose from 6 percent of bank assets in Q1 1988 to 10 percent in Q1 2008."

Be careful here. Larry's point is that there was no voluntaryincreasein leverage, and especially as measured and monitored by regulators, and no such increase was a key cause of the crisis.  That doesn't mean the overall amount of leverage is fine. Larry's main point, as mine, is that the banking system has way too much leverage overall.

5) Too Little [Regulatory] Capital

"According to Cox [ Christopher Cox, Chairman of the U.S. Securities and Exchange Commission (SEC)..], Bear Stearns was well capitalized when it failed, with a capital ratio over 13 percent and a debt-equity ratio of 6 to 1. Indeed, it appears that Bear Stearns could have easily passed the current Dodd-Frank stress test immediately prior to its demise. Consider this statement from Chairman Cox.
"The fate of Bear Stearns was the result of a lack of confidence, not a lack of capital. When the tumult began last week, and at all times until its agreement to be acquired by JP Morgan Chase during the weekend, the firm had a capital cushion well above what is required to meet supervisory standards calculated using the Basel II standard. "
Lehman was also well capitalized prior to its demise. It had tier-1 capital of 11 percent when its creditors pulled the plug. An 11 percent capital ratio is close to the current banking system’s tier-1 capital ratio of 12.3 percent, calculated based on the Federal Reserve’s recent stress tests. This indicates that today’s banking system is no safer than was Lehman Brothers when it was driven out of business."

Again, in this draft, Larry doesn't emphasize enough that the point is adecline in capital, aweakeningof regulations, or a decline in regulatory capital. His and my overall point is that capital needs to be much, much larger overall, and that will stop runs. But the event of the crisis was a combustion of the regular old gas in the basement, not an addition of lots of new gas.

6) Egregious and Predatory Lending


"adjustable-rate mortgages, mortgages with balloon payments, interest-only mortgages, piggy-back, and so-called pay-option ARM loans."

of these,

"...in 2007, before the GR, the foreclosure rate was 5 percent. Its lowest value, between 2002 and 2007, was 3 percent, which was observed in Q3 2005.If one assumes that all of the 2 percentage-point increase in subprimes involved predatory lending, we’re still talking about predatory lending causing, at most, 0.3 percent more mortgages to definitely default, namely, enter foreclosure. This is simply too small a figure to matter to the overall economy. Indeed, given the size of the 2007 mortgage market, it represents just $32 billion. In 2007, U.S. GDP was $14.4 trillion. The economy’s 2007 total net wealth was $68 trillion."

The Dodd-Frank act piled every suggested fix to every perceived financial problem in one place. Even if one regards predatory lending as a problem, even if one does not regard competition as the best disinfectant and guarantor of good treatment, even if one thinks it needs fixing, Larry's point is that such a fix has nothing to do with stopping crises.

7) Dramatic Increases in Household Mortgage Debt

Surely, the addition of over $750 billion in mortgage debt in the course of 6 short years must represent a priori evidence that a massive recession was in the works. Not so. ... The increase in borrowing to purchase homes was not associated with a massive spending spree on the part of the American public. Indeed, the share of GDP consumed by the public remained fixed at roughly 67 percent between early 2002 and late 2007.

What about household debt payment service as a share of disposable personal income? There was an increase prior to the GR, but nothing extraordinary. Between Q4 2001 and Q4 2007, the ratio troughed at 12.1 percent in Q2 2004 and peaked in Q4 2007 at 13.2 percent. A 13.2 percent ratio is small and the increase from trough to peak is only 9 percent

As with houses, your debt is my asset. Larry is verging here into causes of the recession rather than the crisis. There is a case for asymmetries, but the first-order mistake is to think that just because I am in debt we all are in debt.

8) Exponential Growth in Trading Activity by Financial Firms

Here, again, we have a supposed reason for the Great Recession that has no counterpart in economic theory. If Joe and Sally sell the same share of stock back and forth to each other an infinite number of times in, say, a second, nothing real will happen to Joe and Sally or the economy.

9) Unregulated Derivatives and the Repo Market

The reigning narrative – that derivatives were misunderstood and over rated by compliant rating companies – has been questioned in a recent study by economists Juan Ospinal and Harald Uhlig. They examined 8,615 residential mortgage-backed securities (RMBS) over the period 2007-2013, almost all of which were rated AAA. Through 2013, the cumulative loss on these “toxic” securities was only 2.3 percent. Some three quarters of the AAA-rated RMBS had essentially zero losses through 2013. On a principal-weighted basis, the average loss rate was only 0.42 percent.

I think the logic here is that if securities were overpriced, then they should have fallen. That they did not is interesting. Of course, if they had fallen that is not necessarily evidence of overpricing, as there was a huge recession after the run!

Here again I think a big qualification is in order. The run on repo was a central part of the crisis, and I think Larry and I agree that way too much such run-prone financing was the key cause of the crisis. Again, I think the point Larry is making is that the financial system as constructed is always vulnerable, that the crisis was not brought on by some sudden and preventable increase in debt.

10) Investors Mispriced/Ignored Risk

11) Unaligned CEO Incentives

Yet another explanation for the GR is that CEOs of financial institutions had too little “skin in the game.” Jimmy Cayne, former head of Bears Stern, would surely disagree. Cayne lost close to $1 billion as his bank collapsed. Ken Lewis, CEO of the Bank of America, had $190 million to lose by making wrong decisions and succeeded in losing $142 million. Lehman Brothers’ Dick Fuld received most of his 2007 compensation in the form of Lehman Brothers’ stock.

12) Democratization of Finance

Under this theory, government sponsored enterprises (Fanny and Freddie) and government regulators were too permissive with banks in their quest to help the poor get into affordable housing. ...if this were the chief or even a major cause of the GR, subprime mortgages would need to have played a much larger role than they did.

13) The Federal Reserve Kept Interest Rates Too Low

Thirty-year mortgage interest rates were certainly lower between 2000 and 2007 than in the prior quarter century. But they weren’t that low especially adjusted for inflation. In the 1990s, the real 30-year mortgage rate averaged 7.91 percent. It averaged 6.27 between January 2000 and December 2007. This decline is hardly something to write home about, let alone pretend is the underlying GR culprit.


..the foundational bank-run models --- Bryant (1980), Diamond-Dybvig (1983), Pech and Shell (2003) and related models – admit multiple equilibrium in which financial-market collapse arises absent any fundamental financial- or real-sector problem...  from the perspective of these models, the question is not whether the banking system will fail, but when. Hence, it’s passing strange that the FCIC report makes no mention whatsoever of either paper, let alone the theory underlying bank runs.

(My emphasis.) Larry goes on for several pages documenting spreading panic. An earlier quote is good here

SEC Chairman, Mary Schapiro’s, 2010 testimony to the House Financial Services Committee...includes this statement.
The immediate cause of Lehman's bankruptcy filing on September 15, 2008 stemmed from a loss of confidence in the firm's continued viability resulting from concerns regarding its significant holdings of illiquid assets and questions regarding the valuation of those assets. The loss of confidence resulted in counterparties and clearing entities demanding increasing amounts of collateral and margin, such that eventually Lehman was unable to obtain routine financing from certain of its lenders and counterparties

The banks failed because they could. And they could fail because they were leveraged. They falsely promised to make repayments regardless of the circumstances.

Unsafe at Any Speed, and the limits on bailouts

The overall level of leverage is way too high. This reinforces my earlier interpretation of Larry's comment about leverage not being the problem -- there was way too much leverage, but its increase did not directly cause a crisis.

The next part is really interesting.

The Federal Reserve is also leveraged. In the aftermath of Lehman’s collapse, the Fed effectively insured not just checking and saving accounts, but also money market funds. These obligations were officially and, respectively, FDIC and Treasury obligations. They ran to some $6 trillion. But neither institution had $6 trillion in ready cash to make good on its insurance. Hence, the Fed would have been on the hook. Indeed, had things gotten worse, there would surely have been a run on the life insurance industry’s cash-surrender value policies, which, at the time, also totaled roughly $6 trillion.
Now imagine, as discussed in Kotlikoff (2010), that the government’s explicit and implicit pledges of insurance had been called by the public. I.e., suppose the public had, despite the promises of government insurance, headed straight to the banks, money market funds, and insurance companies to empty out their accounts and cash out their cash-surrender value policies. In this case, the Fed would have had to print $12 trillion virtually overnight. The M1 money supply at the time was just $1.5 trillion. Hence, this would have produced fully-justified fears of hyperinflation leading everyone to run for their money before prices soared
The U.S. has yet to experience a run on its central bank. But this is common in countries like Argentina, ...

Larry is, of course, an expert on all the explicit and implicit credit guarantees our government offers. I was unaware that $6 trillion of "cash surrender value policies" existed, and given the bailouts of other insurance policies we would certainly have seen them bailed out too. Fannie and Freddie guarantee most mortgages.

Though it does represent promises of payment, I don't think this really is "leverage" of the Federal Reserve. The government has, in essence, written a lot of put options, which is a different thing.

What happens in an even more massive run, with more massive bailouts is an interesting question. It's not as simple as "print [ing] $12 trillion overnight." The Fed issues reserves, convertible to cash, but always in return for something else. So, this would have put a big strain on the Fed's legal limitations of what collateral it can accept and from who.

The Fed mostly deals with commercial banks. Imagine a massive run on commercial banks, perhaps stemming from a rumored cyberattack that emptied one of them out. The Fed would have to lend against the entire portfolio of bank assets, not just liquid securities. Goodbye Badgehot.

As Larry points out, really the FDIC and Treasury are the ones guaranteeing non-bank debts.  The Treasury would have to borrow $12 billion overnight, sell it to the Fed, and then use it to bail out here and there. The ban on direct Fed-Treasury purchases would make this very hard, and would probably have to be scrapped.

But the huge increase in money would clearly be a temporary increase in money demand, and not obviously inflationary. Moreover, the Treasury, Fed, FDIC, etc. would take on assets. If these operations could be reversed after the panic passes -- if there is not a tremendous amount of actual lost value, as there was not last time, the money could be soaked up again. Even if not, the operation would not be inflationary if people thought the government could retire the debt and soak up the interest-paying reserves by future surpluses. We get inflation -- and Argentina gets inflation -- if and only if this nightmare involves a large fiscal transfer, that the US government cannot or will not pay off, that is financed by a permanent increase in non-interest-paying money.

US Federal debt is about $10 trillion larger than in 2008, and we're running $1 trillion deficits, with no end in sight. The reliability of the fiscal resources to make good on all these put options is, I think, a serious problem, and the heart of the potential inflation Larry describes.

The Role of Opacity

Bear Stearns was among the first to be picked off by those who stood to gain by a financial collapse because it was viewed as particularly opaque
The fact that Bear’s stock was valued at $60 per share one week before JP Morgan bought it for $2 per share (less a $29 billion sale of Bear’s troubled assets to the Fed valued at far less than $29 billion) tells us that no one knew anything about Bear’s assets, either before it died or when it died. Its valuation was, it seems, purely a matter of conjecture. Before it didn’t, the market apparently though Bear’s assets were worth something because everyone else thought its assets were worth something. This too is the stuff of multiple equilibria

Gary Gorton likens financial crises to a salad bar, where someone says "there's a news report of e-coli in the (inaudible)". So what do you do? Absent information on which ingredient has the e-coli, and the time or inclination to investigate, you go order a hamburger.

Now ask yourself, where is there a mountain of debt that can't be repaid, much of it very short term, phoney-baloney accounting, and opaque off-balance-sheet exposures (put options)? Sovereigns.

Bottom line

The first conclusion seems to me spot on. The second one is more provocative. Here Larry signs up with multiple-equilibrium theories of recessions, as well as simple multiple equilibria associated with run-prone assets like overnight debt. It's verbally plausible. If you think there will be a recession tomorrow, you fire workers and do not invest, and there is a recession today. But you can see a crucial derivative needs to be greater than 1.0 for that to work. Lots of formal models have multiple equilibria, but I've spent 10 years putting nominal multiple equilibria back in the new-Keynesian model, and real multiple equilibria are harder to get going.

Choose your equity-financed banking flavor, and we can end financial crises forever. Just why we don't do it seems an important -- and sadly forgotten -- question.

20 Aug 2020

Europe's Banks - Barokong

My visit to Europe resulted in many interesting conversations. There was a stark contrast between the complex regulatory vision of formal presentations and papers, and the lunch and coffee discussion reflecting experience of people involved in actually regulating banks. They seemed to be quite frustrated by the state of things. Disclaimer: this is all completely unverified gossip, and remembered through a fog of jet lag. If commenters have better facts, I'm hungry to hear them.

Risk weights are ungodly complex, and not many people actually understand them, or the layers of buffers and how they are applied.

Risk weights are suspiciously low. Big banks are allowed to use their own models, calibrated on 10 years of data. That means the data have, now, 10 years of stable growth and very low default. Look, say the banks, our investments are nearly risk free.

"Micro" regulators who look at the specifics of an individual bank are prone to offset the "systemic" and "macro-prudential" efforts. Look, say the banks, we have to fulfill all these macro-prudential rules, give us a break. Regulators do.

The financial regulatory community has been preoccupied with writing reports about one thing after another. Meanwhile, the elephant remains in the room:  Italy may default or leave the euro.

Italian banks remain stuffed with Italian government bonds. I learned some new words for this: a "doom loop." If the government defaults, the banks go with it.  Some smaller foreign banks still have large investments in Italian bonds. Another new word: "Moral suasion," governments encouraging banks to buy a lot of their bonds.  I imagine the Godfather had more colorful words for it. On the other hand, Italian banks are reportedly happy for the moment, since as long as Italy doesn't actually default, they make a bundle from high interest rates. Government debt is still treated with low or no risk weights.

In case it isn't obvious here's the problem. A sovereign default is bad enough. But if the banks are stuffed with government debt, then a sovereign default brings down the banking system. Depositors lose their shirts, and the banks, who know how to distinguish good from bad borrowers, are shut down. A calamity becomes a catastrophe. And an economy with failing banks will be bringing in a lot less tax revenue and more likely to default.  Government debt in a currency union without banking union is a singularly bad investment, because as currently construed governments give deposit insurance (explicit or implicit).

All this is obvious to anyone looking at it, and leads to a big sigh about "political pressure." 10 years on, and Europe can't quite bring itself to say that sovereign debts are risky. Understandably. This is a club of equals, and it's awfully hard to say that some debts are better than others.

But this elephant has been careening around the room for 10 years. There was a Greek crisis which should have gotten some attention!

Some want a full banking union, breaking local bank regulation and allowing large transnational  banks to operate fully, breaking the doom loop. Some want full fiscal union to go with monetary union. The current model, pressure from the rest of Europe for governments not to borrow so much, and thus to never face a potential sovereign default, has clearly failed.

In my view, monetary union without fiscal union works fine, so long as we all understand that governments can default, and their debt should be treated just as risky (and sometimes junk) corporate debt on bank balance sheets. And, of course, if capital requirements were doubled, tripled, or more, so that banks could sail through a sovereign default, the problem would solve itself.

It occurs to me that simply removing risky local government debt from banks would go a long way to solving the problem. Defaultable government debt should be held via floating-NAV mutual funds, not via bank accounts.

Additionally, there is a big kerfuffle going on that Italy's central bank owes Germany's a lot of money.   Italians see this coming, and there is a lot of capital flight out of Italy. When an Italian writes a check from an Italian bank to buy an apartment in Germany, the money flows from Italian bank to Italian central bank, to German central bank, to German bank. Except the Italian central bank essentially makes a promise to pay rather than actually paying. Italy is basically expanding government debt in this way. I don't totally understand it, nor did most people I talked to about it, and there is a wide disagreement whether this is another debt or just an accounting glitch. Still, that most people at a financial regulation conference know this is a big problem and nobody is quite sure what it means is telling.

With this background of lunchtime and coffee conversations, the written products of the financial regulation community have a surreal quality. The illusion of technocratic competence is always present in bank regulation discussions, but even more stark with this backdrop.

Look for example at the website of theFinanical Stability Board and the issues it thinks are important. As one example, the summary of FSB priorities for the Argentine G20 Presidency. It starts well enough, "Vigilant monitoring to identify, assess and address new and emerging risks." But what's the number one such risk? You would think, in honor of the Argentine presidency, with Italy the number one topic of conversation at lunch, and with who knows who owes who what in China, it would be "sovereign risk." Nope. Crypto-assets is number 1: "The FSB will identify metrics for enhanced monitoring of the financial stability risks posed by crypto-assets and update the G20 as appropriate." Then,

Disciplined completion of the G20’s outstanding financial reform priorities....During the course of the year the deliverables to the G20 will include the following areas: the correspondent banking Action Plan including improving the access of remittance providers to banking services; a toolkit for firms and supervisors on the use governance frameworks to reduce misconduct in the financial sector; leverage measures for investment funds to support resilient market-based finance; guidance on financial resources available to support central counterparty (CCP) resolution to deliver resilient and resolvable CCPs; a cyber security lexicon to support consistency in the work of the FSB, standard-setting bodies, authorities and private sector participants; and the private sector-led Task Force on Climate-related Financial Disclosures’ report on voluntary implementation of its recommendations to highlight good practice and foster wider adoption.
Sovereign risk is not mentioned once in this document. And I did not find it anywhere on the FSB website.

If you read between the lines, there is a very worthy reaction to this tendency to produce complex hot air that changes with each presidency:

Pivoting to policy evaluation to ensure the reform programme is efficient, coherent and effective. The FSB is increasingly pivoting away from design of new policy initiatives towards dynamic implementation and rigorous evaluation of the effects of the agreed G20 reforms.

State of thought on financial regulation - Barokong

I'm at a conference on "Financial cycles and regulation" at the Deutsche Bundesbank. Beyond the individual papers, I find the conversation interesting.

Groups of researchers develop a common language and a common set of assumptions. This is productive -- to push a research frontier we have to agree on a few basic ideas, rather than argue about basics all the time. I, as an outsider, parachute in, and learn as much what the shared assumptions are, as I do about particular points in elaboration of the program.

Here,  it is pretty much taken for granted that there is such a thing as a "financial cycle." It's in the conference title, after all! That means a "cycle" of credit expansion, usually "unwarranted," "excessive," or an "imbalanced," followed by a bust. It is also agreed that it is the job of financial regulators to manage this "cycle."

In his Keynote speech, Claudio Borio of the BIS described a sort of Taylor rule, in which monetary and financial policies should respond systematically to the "credit gap." Jan Hannes Lang described a model for estimating that "credit gap." Marco Lombardi applied Jim Stock's time-deformation models to characterize the "financial cycle." Michael McMahon showed a very elegant model in which banks over-lend and hence society over-invests in good times. The government bails out in bad times, so the discount factor for investment excludes bad-time outcomes.  (All paper titles at the above program link, papers aren't posted yet but you can google them.)

I parachute in from the outside. Understanding this language and shared set of assumptions is important.  I'm a bit skeptical, of course. Yes, there is regression evidence that large debts and high prices forecast crises. But there is always supply and demand in economics, always the possibility of a boom rather than a bubble. "Large" is not always "excessive." And the passage from an interesting set of historical correlations to structural understanding to something stable enough, and without unintended consequences, for policy exploitation seems to have passed while I was napping. As McMahon pointed out, credit controls in the 1970s were not a huge success. But these are just the skeptical questions of a newcomer. I come to conferences to listen primarily.

My own view is that the crisis was a run, and the central way to stop runs is with lots more capital and lots less short-term debt. Then you can have booms and busts without runs. I note ruefully that capital is under attack in the US, and that 10 years after the crisis, so much for those countercyclical buffers. Karsten Müller presented some nice regression evidence that governments typically loosen regulations just before elections, as the US just did.  Systematic countercyclical capital remains remains a dream in the eyes of many writers especially at the Fed, BIS, and other institutions. Monetary and "macro-prudential" policy that successfully and systematically lowers house and asset price volatility is even further away. How much nicer if the financial system were run-proof and did not require so much management.

At least though, this little discussion reflects a large agreement that capital is the central buffer and so much else in current regulation is not very useful.

19 Aug 2020

Financial Choice - Barokong

If you're interested in policy rather than politics, the package of legislative proposals coming out of Congress are a lot more interesting than the Presidential race at the moment. Speaker Paul Ryan is rolling out "A Better Way" package and Rep. Jeb Hensarling has just announced a "financial CHOICE act" to fundamentally reform Dodd-Frank. (Most quotes are fromJeb Hensarling's speech at the Economic Club of New York. See alsoNYT coverage.)

These efforts will, I think, become much more important later on. The presidential race will decide whether this agenda can survive the instant veto that it faces now.  (This is a non-partisan comment. Hilary Clinton could likely assure a landslide by announcing she will work with Paul Ryan to craft and pass it.)

In any case, it defines a clear program that may be the focus of economic policy under a presidency of either party. And I think that's healthy as well.  We are still living in the shadows of Franklin Roosevelt's 100 days, and an increasingly imperial presidency. But the current need is not for a flurry of new legislation and executive orders to address a crisis. We need a steady clean-up of the legal and regulatory mess of the last few decades. For that project, it may be better for policy leadership to come from Congress, and by careful and patient drafting of actual legislation.

The legislation is still being drafted, which is why it would be lovely if more of the media and blogosphere were paying attention rather than to the latest antics of the presidential candidates. The congressional staff writing these things are paying attention and the proposals can be refined!

Today, a look at the Financial CHOICE act.

More capital, and the carrot of less regulation

...there is a growing consensus surrounding the idea of a tradeoff between heightened capital levels and a substantially lower regulatory burden....[We] will relieve financial institutions from regulations that create more burden than benefit in exchange for meeting higher, yet simple, capital requirements...Think of it as a market-based, equity financed Dodd-Frank off- ramp... the option remains with the bank.

How to measure capital? This is a hard nut.

...banks that maintain a simple leverage ratio of at least 10 percent and, at the time of the election, have a composite CAMELS rating of 1 or 2 may elect to be functionally exempt from the post-Dodd-Frank supervisory regime, the Basel III capital and liquidity standards, and a number of other regulatory burdens that pre-date Dodd-Frank.
This is an element worthy of more discussion. Leverage ratios have problems too, as they do not distinguish the riskiness of assets.  CAMELS ratings have their own problems.

As blog readers know, I think we can keep going well beyond 10% capital. I'd like to see steady incentives for more and more capital, rather than an arbitrary threshold.  My current thinking leads to reducing subsidies for debt, a fee on short term debt, and using ratios of market value of equity to debt. Or a schedule of regulatory reductions: so much for 10% capital, more for 20% capital, do what you want at 100%. But we're in danger here of repeating a Libertarian party sort of fight whether there should be drivers' licenses in Nirvana, so let's leave this as an open question for refinement.

It seems natural to ask for more capital on riskier assets, but a beautiful paragraph on risk-weights explains why that doesn't work.

Risk-weighting is simply not as effective. First, it is far too complex, requiring millions of calculations to measure capital adequacy. Second, it confers a competitive advantage on those large financial institutions that have the resources to navigate its mind-numbing complexity. Third, regulators have managed to get the risk weights tragically wrong, for example, treating toxic mortgage-backed securities and Greek sovereign debt as essentially risk-free. One myopic globally imposed view of risk is itself risky. Finally, risk-weighting places regulators in the position of micro-managing financial institutions, which politicizes credit allocation. Witness the World Bank recently advertising its zero risk rating under the Basel Accords for their “green bonds.”
The regulatory carrot: A bank with enough capital

would be deemed “well capitalized” for prompt corrective action purposes; It would no longer be subject to Basel Committee capital or liquidity requirements as implemented by the U.S. banking regulators;  It would be able to make capital distributions freely; and would additionally be able to consummate transactions without being subject to the regulatory challenge of increasing risk to the stability of our banking or financial system, or on grounds related to capital or liquidity standards of concentrations of deposits or assets.
... no Federal rule establishing “heightened prudential standards” of the type provided for in Dodd-Frank would apply to qualifying banking organizations, including the living will requirement...In short, a strongly capitalized qualifying bank will be enabled to remove government bureaucrats from its boardroom and lend and invest freely.

From the executive summary,

Exempt banking organizations that have made a qualifying capital election from any federal law, rule, or regulation that permits a banking agency to consider risk “to the stability of the United States banking or financial system,” added to various federal banking laws by Section 604 of the Dodd-Frank Act, when reviewing an application to consummate a transaction or commence an activity.

A linguistic note: Not once in this speech, except while quoting others, does Rep. Hensarling use the phrase "to hold" capital. Every instance is "raise" capital. And explicitly,

equity capital can be put to work no differently than debt or deposits. It is not money put under a mattress.

And as to the ballyhooed impossibility of raising capital,

U.S. banks have raised hundreds of billions in new capital
Who says nobody in Congress understands finance!

Bankruptcy; no more "designation"

The centerpiece of Dodd-Frank is the FSOC (Financial Stability Oversight Council's) ability to "designate" a firm as "systemically important," and then to "resolve" it, in place of bankruptcy.  This will go.

...bankruptcy, not bailouts. Recently the House passed the bipartisan Financial Institution Bankruptcy Act, which creates a new subchapter of the Bankruptcy Code tailored to specifically address the failure of a large, complex financial institution.....
The speech goes on with several good reasons bankruptcy is better than resolution.  I hear cheering from John Taylor's office already.

 Retroactively repeal the authority of the Financial Stability Oversight Council (FSOC) to designate firms as systematically important financial institutions (SIFIs)
Fed Lending

...we impose on the Fed Bagehot’s famous dictum: lend freely, but only to solvent institutions, only against sound collateral, and only at interest rates high enough to dissuade those who are not genuinely in need.
I'm a little leery of this one. Dictums are not analysis. If you want to stop a run, you have to lend pretty freely. Private institutions like a clearinghouse to do that once existed, but they have been put out of business by the Fed.  Nobody knows who is solvent vs. illiquid; the point of a run is that collateral that was "sound" yesterday is not today.  And if you want to stop a run, who cares if it's insolvent or illiquid? The Fed doesn't need quickly salable collateral, being super senior in bankruptcy is enough.  Bagehot's dictum is a great way to run a hedge fund. It's not necessarily the right way to run a central bank.

I worry that we are headed for the worst of all worlds -- people expect bailouts and free fed lending, but the government is legally constrained from doing so. All the moral hazard and none of the crisis mop. If we're going to go in this direction, it has to be crystal clear to people running banks that the government will not be able to step in next time, even stretching laws, and they'd better set things up carefully ahead of time. I'm afraid people are not going to believe any legal restrictions.

Rule of Law

Some of the most interesting parts of this proposal really belong together in "restoring the rule of law to regulation." That's a big project that I hear simmering in much of this Congressional planning. And, based on the daily news (for example the latest on the FCC takeover of the internet) not a minute too soon.


The "Consumer Financial Protection Bureau" is out of control.

fundamentally reforming the CFPB......task it with the dual mission of consumer protection and competitive markets, with a cost-benefit analysis of rules performed by an Office of Economic Analysis.
 Replace the current single director with a bipartisan, five-member commission which is subject to congressional oversight and appropriations.
... Repeal authority to ban bank products or services it deems “abusive” and its authority to prohibit arbitration. ... Repeal indirect auto lending guidance.
Federal Reserve

One of the most thought-provoking proposals splits the Federal Reserve's regulatory power from its monetary policy power. It puts bank regulation, like all regulation, in the rule-of-law framework that is supposed to exist for regulation: cost-benefit analysis, Administrative Procedures Act, Congressional oversight, and so forth. Various quotes:

Require that the different sets of conditions under which stress tests are evaluated subject to notice and comment period.
... makes sure every financial regulation passes a rigorous cost-benefit test...
We will put all the financial regulatory agencies on budget. The bare minimum level of accountability to “We the People” is to have their elected representatives in Congress control the power of the purse, as inscribed in our Constitution.
But, wisely,

protects the Federal Reserve’s independence in conducting monetary policy by leaving that function off-budget. The Fed’s prudential regulatory and financial supervision activities, however, will now be subject to the normal and transparent congressional appropriations process.

...due process rights. Too many citizens have been “shook down” or abused by their government. Thus we will provide an immediate right of removal to federal court for respondents in administrative proceedings.  We will ensure that disciplinary proceedings are public, that all fines imposed by regulatory agencies are sent to the Treasury for deficit reduction, that regulatory entities created by Congress are subject to full congressional oversight, and that other due process rights are strengthened.
There is a curious section on increasing the SEC's power:

the Financial CHOICE Act will impose the toughest penalties in history for financial fraud, self- dealing and deception.
We will double the cap for the most serious securities law violations and will allow for triple monetary fines when penalties are tied to illegal profits. We will give the SEC new authority to impose sanctions more closely linked to investor losses – and increase punishments even more for repeat offenders. We will increase the maximum criminal fines for both individuals and firms that engage in insider trading.
I'm not aware of a big problem in the SEC (and DOJ) not being able to ruin people's lives adequately, or extort large enough settlements from banks. Perhaps this is an olive branch, which won't hurt much.

Broader project

A sense of the broader project to restore rule of law in regulation.

Dodd-Frank gives FSOC the ability to designate companies as Too Big to Fail if it “determines that material financial distress” at the company “could pose a threat to the financial stability of the United States.” But nowhere in Dodd-Frank, or anywhere else in the U.S. Code for that matter, are these terms defined. So by defining these vague terms in any fashion that pleases them, this “super-group” of regulators can exert ultimate functional control over almost any large financial firm in our economy, and do so with utter disregard for due process. This is not the rule of law; it is the rule of rulers, and it’s an anathema to a free and democratic society....
Next, we repeal the Chevron doctrine requiring the judiciary to give deference to financial regulatory agencies’ interpretation of the law. The doctrine is unfair and an affront to due process and justice.
I've gone on long enough. Legislation needs a public comment mechanism too, as this is  a big package, which though on a very good track can surely be refined a bit.

16 Aug 2020

Blueprint for America - Barokong

Some of the inspiration for this project came from the remarkable 1980 memo (here) to President-elect Ronald Reagan from his Coordinating Committee on Economic Policy.

Like that memo, this is a book about governance, not politics.  It's not partisan -- copies are being sent to both campaigns. It's not about choosing or spinning policies to attract voters or win elections.

The book is about long-term policies and policy frameworks -- how policy is made, return to rule of law, is as important as what the policy is --  that can fix America's problems. It focuses on what we think are the important issues as well as policies to address those issues -- it does not address every passion of the latest two-week news cycle.

The book comprises the answers we would give to an incoming Administration of any party, or incoming Congress, if they asked us for a policy package that is best for the long-term welfare of the country.

The chapters, to whet your appetite:


CHAPTER 1: The Domestic Landscape by Michael J. Boskin

IN BRIEF: Spending by George P. Shultz

CHAPTER 2: Entitlements and the Budget by John F. Cogan

CHAPTER 3: A Blueprint for Tax Reform by Michael J. Boskin

CHAPTER 4: Transformational Health Care Reform by Scott W. Atlas

CHAPTER 5: Reforming Regulation by Michael J. Boskin

CHAPTER 6: National and International Monetary Reform by John B. Taylor

CHAPTER 7: A Blueprint for Effective Financial Reform by John H. Cochrane

IN BRIEF: National Human Resources by George P. Shultz

CHAPTER 8: Education and the Nation’s Future by Eric A. Hanushek

CHAPTER 9: Trade and Immigration by John H. Cochrane

IN BRIEF: A World Awash in Change

CHAPTER 10: Restoring Our National Security by James O. Ellis Jr., James N. Mattis, and Kori Schake

CHAPTER 11: Redefining Energy Security by James O. Ellis Jr.

CHAPTER 12: Diplomacy in a Time of Transition by James E. Goodby

CLOSING NOTE: The Art and Practice of Governance by George P. Shultz

My chapter on a Blueprint for Effective Financial Reform is a better version of the talk on Equity Financed banking which I posted here. (The talk was based on the paper. Now you have the paper.)

My chapter on Trade and Immigration is new, and an uncompromising red-meat free-market view. I don't think one should compromise centuries old economic understanding just because it's not politically popular at the moment.

If you got this far, you might also be interested in my Economic Growth essay written for a parallel but similar project.

15 Aug 2020

A world without cash - Barokong

Max Raskin and David Yermack have a nice WSJ OpEd last week, "Preparing for a world without cash." The oped summarizes their relatedpaper.

What would a government-backed digital currency look like? A country’s central bank would need to become a deposit-taking institution and hold accounts on behalf of citizens and businesses. All of their debits would be tracked on the central bank’s blockchain, a digital ledger resistant to tampering. The central bank would pay interest electronically by adjusting the balances of depositor accounts.
I'm a big fan of the idea of abundant interest-bearing electronic money, and that the Fed or Treasury should provide abundant amounts of it. (Some links below.) Two big reasons: First, we then get to live Milton Friedman's optimal quantity of money. If money pays interest, you can hold as much as you'd like. It's like running a car with all the oil it needs. Second, it is a key to financial stability. If all "money" is backed by the Treasury or Fed, financial crises and runs end. As Max and David say,

Depositors would no longer have to rely on commercial banks to hold their checking accounts, and the government could get out of the risky deposit-insurance business. Commercial banks that wished to keep making loans would raise long-term capital in the debt and equity markets, ending the mismatch between demand deposits and long-term loans that can cause liquidity problems.
However, there are different ways to accomplish this larger goal. Do we all need to have accounts directly at the Fed, and is a blockchain the best way for the Fed to handle transfers?

The point of the blockchain, as I understand it, is to demonstrate the validity of each "dollar" by keeping a complete encrypted record of its creation and each person who held it along the way.

Its archival blockchain links together all previous transfers of a given unit of currency as a method of authentication. The blockchain is known as a “shared ledger” or “distributed ledger,” because it is available to all members of the network, any one of whom can see all previous transactions into or out of other digital wallets
That, and a limited supply to control its value, was the basic idea of bitcoin. But when we are clearing transactions by transferring rights to accounts at the Fed, the validity of the "dollar" is not in question. It's at the Fed. And, the big advantage relative to bitcoin as I see it, the value of the dollar comes from monetary policy and ultimately the government's demand for "dollars" to be paid in taxes, not from a fixed supply as was the case with gold.

The blockchain also appears to clear transactions more quickly and offer some security advantages. The latter are very attractive -- in my personal life I've recently had the questionable pleasure of spending days enjoying 19th century finance of multi-day clearing times, obtaining notarized signatures and medallion guarantees, and sending pieces of paper around. But not yet ironclad -- The same week of the WSJ has a string of articles on the security ofBitcoin following a recent hack.

The biggest stumbling block in my mind is "all members of the network, any one of whom can see all previous transactions into or out of other digital wallets." Per Max and David, this has pluses and minuses:

Tax collection would become much simpler, and tax evasion and money laundering could become prohibitively difficult.
Yet the centralization of banking under this system would also create a Leviathan with the power to monitor and control the personal finances of every citizen in the country. This is one of the chief reasons why many are loath to give up on hard currency. With digital money, the government could view any financial transaction and obtain a flow of information about personal spending that could be used against an individual in a whole host of scenarios.
This really is a big change in how "money" works. Traditional cash has a lovely property, that it has no memory. Its physical properties determine its value in a way independent of its history. It is incredibly efficient, in a Hayek information sense. The economy does not need the memory of every transaction. Blockchains turn this around.

The anonymity of cash makes it enduringly popular -- cash holdings are up, not down in the digital age. The same week of WSJ reading had articles delving into the continuing popularity of cash, and themechanics of handling it, the ongoing fury over theplaneload of cashdelivered by the Obama administration to Iran. It's not hard to figure out why both Iranians and Administration needed to send old-fahshioned bills on an unmarked plane, not a wire transfer.

Indeed creating this Leviathan is a danger, to the economy, and to our political freedom. Our government likes to pass aspirational laws that we don't really mean to enforce. Get rid of cash, and allow the government to see every transaction and enforce every law regarding payment of anything, and 11 million immigrants suddenly can't work at all and become penniless. Rigorous enforcement of all transactions would not only stop your kids lemonade stand and babysitting business, it would wipe out most of the employment opportunities for lower-income America. Many businesses would come to a halt.

The natural response is, well, maybe we shouldn't pass laws we don't really mean to enforce. Good luck with that.

More deeply,  "flow of information about personal spending that could be used against an individual in a whole host of scenarios" is truly frightening. I don't think there is a political candidate in the whole country who could not be embarrassed with one purchase at some point in their lives. Consider the brouhaha now over "disclosure" of political contributions -- there is a real fear that disclosure is a way of setting up hit lists for the administration to go after its political enemies. Multiply that by a thousand. Dissenters could easily be silenced if the government can monitor or block every transaction.

The ability to transact with anonymity and privacy has been a central freedom for hundreds of years. It's largely gone already. Losing it entirely and giving the government huge power to enforce any law it passes is not necessarily a good thing.

Mike and David opine

creating and respecting privacy firewalls and rethinking legal-tender laws could mitigate the dangers of monopoly and stifled competition in currency markets.
[Subject-free sentences (creating?) are always a sign of trouble!] The dangers are not of monopoly and competition, the dangers are in the vast loss of privacy that the government, and its leakers and hackers knowing all our transactions implies.

(Here I'm out on a limb on my blockchain knowledge, but I gather that one does have to wipe the slate clean occasionally. Otherwise, the blockchain gets ridiculously long. Imagine each dollar, a hundred years from now, attached to a list of everyone who has ever held it! That wiping out process could do a lot for privacy.)

So, back to basics. It is not at all clear to me in their analysis why the Fed has to manage all the accounts. The Fed, Treasury, and the government in general are very good at defining the units of a currency, and providing an easy standard of value -- cash, coins, liquid government debt, reserves.  That is their natural monopoly. I don't see that the government has a similar natural advantage in providing low-cost transactions services, especially on monitoring fraud in the use of those services. The Fed got hacked by employees of the central bank of Bangladesh.

So I leave with two big questions -- and these are questions, and this is an invitation to more thought.

Is a blockchain really better than accounts at the Fed, and instructions to flip a switch to send money from my account to your account? What is the best way to get low transactions costs and fraud prevention, given that we don't need authentication of the dollar itself and a supply limitation?

Is it really better for the Fed to handle all transactions directly, rather than for the Fed to provide clearing accounts, and "banks" (narrow!) to provide transactions services between people, using reserves as now for netting and clearing? The latter setup allows competition and innovation in transactions services, and a better hope for an information firewall retaining some privacy and anonymity in transactions.

(Note for readers new to the blog: I've written about some of these issues inA new structure for US Federal Debt, Toward a run-free financial system, A blueprint for effective financial reform and previous blog posts, such as here.)

11 Aug 2020

Testimony - Barokong

I was invited to testify at a hearing of the House budget committee on Sept 14. It's nothing novel or revolutionary, but a chance to put my thoughts together on how to get growth going again, and policy approaches that get past the usual partisan squabbling. Here are my oral remarks. (pdf version here.) The written testimony, with lots of explanation and footnotes, is here. (pdf) (Getting footnotes in html is a pain.)

Chairman Price, Ranking Member Van Hollen, and members of the committee: It is an honor to speak to you today.

Sclerotic growth is our country’s most fundamental economic problem. If we could get back to the three and half percent postwar average, we would, in the next 30 years, triple rather than double the size of the economy—and tax revenues, which would do wonders for our debt problem.

Why has growth halved? The most plausible answer is simple and sensible: Our legal and regulatory system is slowly strangling the golden goose of growth.

How do we fix it? Our national political and economic debate just makes the same points again, louder, and going nowhere. Instead, let us look together for novel and effective policies that can appeal to all sides.


Let’s get past “too much” or “too little” regulation, and fix regulation instead.

Regulation is too discretionary – people can’t read the rules and know what to do. Regulatory decisions take forever. Regulation has lost rule-of-law protections. Agencies are cop, prosecutor, judge, jury and executioner all rolled in to one. Most dangerous of all, regulation is becoming more politicized.

Congress can fix this.

Social programs

Let’s get past spending “more” or “less” on social programs, and fix them instead.

Often, if you earn an extra dollar, you lose more than a dollar of benefits. No wonder people get stuck. If we fix these disincentives, we will help people better, encourage growth and opportunity--and in the end we will spend less.

Spend more to spend less.

Spending is a serious problem. But moving spending off the books does not help.

For example, we allow a mortgage interest tax deduction. This is exactly the same as collecting taxes, and sending checks to homeowners – but larger checks for high income people, people who borrow a lot, and people who refinance often.

Suppose we eliminate the mortgage deduction, and put housing subsidies on budget. The resulting homeowner subsidy would surely be a lot smaller, help lower-income people a lot more, and be better targeted at getting people in houses.

The budget would look bigger. But we would really spend less -- and grow more.


Tax reform fails because arguments over the level of taxes, subsidies, or redistribution torpedo sensible simplifications. We could achieve tax reform by separating its four confounding issues.

First, determine the structure of taxes, to raise revenue with minimal economic damages, but leave the rates blank. Separately negotiate the rates. Put all tax incentives in a separate subsidy code, preferably as visible on-budget expenditures. Add a separate income-redistribution code. Then necessary big fights over each element need not derail the others.

A massive simplification of the tax code is, I think, more important than the rates – and easier for us to agree on.

Debt and deficits

Each year the CBO correctly declares our long-term debt unsustainable. Yelling louder won’t work.

First, let’s face the big problem: a debt crisis, when the U.S. suddenly needs to borrow a lot and roll over debts, and markets refuse. This, not a slow predictable rise in interest rates and crowding out, strikes me as the biggest problem.  Crises are always sudden and unexpected, like earthquakes and wars. Even Greece could borrow at remarkably low rates. Until, one day, it couldn’t.

The answers are straightforward. Sensible reforms to Social Security and Medicare are on the table. Address underfunded pensions, widespread credit and bailout guarantees.

Buy some insurance. Like every homeowner shopping for a mortgage, the US chooses between a floating rate, lower initially, and a fixed rate, higher initially, but forever insulating the budget from interest rate risks, which are the essential ingredient of a debt crisis. Direct the Treasury and Fed to buy the fixed rate.

Above all, undertake this simple, pro-growth economic policy, and grow out of debt.

Concluding comments

You may object that fundamental reform is not “politically feasible.” Well, what’s “politically feasible” changes fast these days.

Winston Churchill once said that Americans can be trusted to do the right thing, after we’ve tried everything else. Well, we’ve tried everything else. It’s time to do the right thing.

9 Aug 2020

Volume and Information - Barokong

This is a little essay on the puzzle of volume, disguised as comments on a paper by Fernando Alvarez and Andy Atkeson, presented at theBecker-Friedman Institute Conference in Honor of Robert E. Lucas Jr. (The rest of the conference is really interesting too, but I likely will not have time to blog a summary.)

Like many others, I have been very influenced by Bob, and I owe him a lot personally as well. Bob pretty much handed me the basic idea for a "Random walk in GNP" on a silver platter. Bob'sreview of a report to the OECD, which he might rather forget, inspired the Grumpy Economist many years later. Bob is a straight-arrow icon for how academics should conduct themselves.

On Volume:  (alsopdf here)

Volume and Information. Comments on “Random Risk Aversion and Liquidity: a Model of Asset Pricing and Trade Volumes” by Fernando Alvarez and Andy Atkeson

John H. Cochrane

October 7 2016

This is a great economics paper in the Bob Lucas tradition: Preferences, technology, equilibrium, predictions, facts, welfare calculations, full stop.

However, it’s not yet a great finance paper. It’s missing the motivation, vision, methodological speculation, calls for future research — in short, all the BS — that Bob tells you to leave out. I’ll follow my comparative advantage, then, to help to fill this yawning gap.

Volume is The Great Unsolved Problem of Financial Economics. In our canonical models — such as Bob’s classic consumption-based model — trading volume is essentially zero.

The reason is beautifully set out in Nancy Stokey and Paul Milgrom’s no-trade theorem, which I call the Groucho Marx theorem: don’t belong to any club that will have you as a member. If someone offers to sell you something, he knows something you don’t.

More deeply, all trading — any deviation of portfolios from the value-weighted market index — is zero sum. Informed traders do not make money from us passive investors, they make money from other traders.

It is not a puzzle that informed traders trade and make money. The deep puzzle is why the uninformed trade, when they could do better by indexing.

Here’s how markets “should” work: You think the new iPhone is great. You try to buy Apple stock, but you run in to a wall of indexers. “How about $100?” “Sorry, we only buy and sell the whole index.” “Well, how about $120?” “Are you deaf?” You keep trying until you bid the price up to the efficient-market value, but no shares trade hands.

As Andy Abel put it, financial markets should work like the market for senior economists: Bids fly, prices change, nobody moves.

And, soon, seeing the futility of the whole business, nobody serves on committees any more. Why put time and effort into finding information if you can’t profit from it? If information is expensive to obtain, then nobody bothers, and markets cannot become efficient. (This is the Grossman-Stiglitz theorem on the impossibility of efficient markets.)

I gather quantum mechanics is off by 10 to the 120th power in the mass of empty space, which determines the fate of the universe. Volume is a puzzle of the same order, and importance, at least within our little universe.

Stock exchanges exist to support information trading. The theory of finance predicts that stock exchanges, the central institution it studies, the central source of our data, should not exist. The tiny amounts of trading you can generate for life cycle or other reasons could all easily be handled at a bank. All of the smart students I sent to Wall Street for 20 years went to participate in something that my theory said should not exist.

And it’s an important puzzle. For a long time, I think, finance got by on the presumption that we’ll get the price mostly right with the zero-volume theory, and you microstructure guys can have the last 10 basis points. More recent empirical work makes that guess seem quite wrong. It turns out to be true that prices rise when a lot of people place buy orders, despite the fact that there is a seller for each buyer. There is a strong correlation between the level of prices and trading volume — price booms involve huge turnover, busts are quiet.

At a deeper level, if we need trading to make prices efficient, but we have no idea how that process works, we are in danger that prices are quite far from efficient. Perhaps there is too little trading volume, as the rewards for digging up information are not high enough! (Ken French’s AFA presidential speech artfully asks this question.)

Our policy makers, as well as far too many economists, jump from not understanding something, to that something must be wrong, irrational, exploitative, or reflective of “greed” and needs to be stopped. A large transactions tax could well be imposed soon. Half of Washington and most of Harvard believes there is “too much” finance, meaning trading, not compliance staff, and needs policy interventions to cut trading down. The SEC and CFTC already regulate trading in great detail, and send people to jail for helping to incorporate information in to prices in ways they disapprove of. Without a good model of information trading those judgments are guesses, but equally hard to refute.

How do we get out of this conundrum? Well, so far, by a sequence of ugly patches.

Grossman and Stiglitz added “noise traders.” Why they trade rather than index is just outside the model.

Another strand, for example Viral Acharya and Lasse Pedersen’s liquidity based asset pricing model, uses life cycle motives, what you here would recognize as an overlapping generations model. They imagine that people work a week, retire for a week, and die without descendants. Well, that gets them to trade. But people are not fruit flies either.

Fernando and Andy adopt another common trick — unobservable preference shocks. If trade fundamentally comes from preferences rather than information then we avoid the puzzle of who signs up to lose money.

I don’t think it does a lot of good to call them shocks to risk aversion, and tie them to habit formation, as enamored as I am of that formulation in other contexts. Habit formation induces changes in risk aversion from changes in consumption. That makes risk aversion shocks observable, and hence contractable, which would undo trading.

More deeply, to explain volume in individual securities, you need a shock that makes you more risk averse to Apple and less risk averse to Google. It can be done, but it is less attractive and pretty close to preferences for shares themselves.

Finally, trading is huge, and hugely concentrated. Renaissance seems to have a preference shock every 10 milliseconds. I last rebalanced in 1994.

The key first principle of modern finance, going back to Markowitz, is that preferences attach to money — to the payoffs of portfolios — not to the securities that make up portfolios. A basket of stocks is not a basket of fruits. It’s not the first time that researchers have crossed this bright line. Fama and French do it. But if it is a necessary condition to generate volume, it’s awfully unpalatable. Do we really need to throw out this most basic insight of modern finance?

Another strain of literature supposes people have “dogmatic priors” or suffer from “overconfidence.” (José Scheinkman and Wei Xiong have a very nice paper along these lines, echoing Harrison and Kerps much earlier.) Perhaps. I ask practitioners why they trade and they say “I’m smarter than the average.” Exactly half are mistaken.

At one level this is a plausible path. It takes just a little overconfidence in one’s own signal to undo the no-trade-theorem information story — to introduce a little doubt into the “if he’s offering to sell me something he knows something I don’t” recursion.

On the other hand, understanding that other people are just like us, and therefore inferring motives behind actions, is very deep in psychology and rationality as well. Even chimps, offered to trade a banana for an apple, will check to make sure the banana isn’t rotten.

(Disclaimer: I made the banana story up. I remember seeing a science show on PBS about how chimps and other mammals that pass the dot test have a theory of mind, understand that others are like them and therefore question motives. But I don’t have the reference handy. Update: A friend sends this and this.)

More deeply, if you are forced to trade, a little overconfidence will get it going. But why trade at all? Why not index and make sure you’re not one of the losers? Inferring information from other’s offer to trade is only half of the no-trade theorem. The fact that rational people don’t enter a zero-sum casino in the first place is the other, much more robust, half. That line of thought equates trading with gambling — also a puzzle — or other fundamentally irrational behavior.

But are we really satisfied to state that the existence of exchanges, and the fact that information percolates into prices via a series of trades, are facts only “explainable" by human folly, that would be absent in a more perfect (or perfectly-run) world?

Moreover, that “people are idiots” (what Owen Lamont once humorously called a “technical term of behavioral finance”) might be a trenchant observation on the human condition. But, by being capable of “explaining” everything, it is not a theory of anything, as Bob Lucas uses the word “theory.”

The sheer volume of trading is the puzzle. All these non-information mechanisms — life-cycle, preference shocks, rebalancing among heterogeneous agents (Andy Lo and Jiang Wang), preference shifts, generate trading volume. But they do not generate the astronomical magnitude and concentration of volume that we see.

We know what this huge volume of trading is about. It’s about information, not preference shocks. Information seems to need trades to percolate into prices. We just don’t understand why.

Does this matter? How realistic do micro foundations have to be anyway? Actually, for Andy and Fernando’s main purpose, and that of the whole literature I just seemed to make fun of, I don’t think it’s much of a problem at all.

Grossman and Stiglitz, and their followers, want to study information traders, liquidity providers, bid-ask spreads, and other microstructure issues. Noise traders, “overconfidence,” short life spans, or preference shocks just get around the technicalities of the no-trade theorem to focus on the important part of the model, and the phenomena in the data it wants to match. Andy and Fernando want a model that generates the correlations between risk premiums and volume. For that purpose, the ultimate source of volume and why some people don’t index is probably unimportant.

We do this all the time. Bob’s great 1972 paper put people on islands and money in their hands via overlapping generations. People live in suburbs and hold money as a transactions inventory. OLG models miss velocity by a factor of 100 too. (OLG money and life-cycle volume models are closely related.) So what? Economic models are quantitative parables. You get nowhere if you fuss too much about micro foundations of peripheral parts. More precisely, we have experience and intuition that roughly the same results come from different peripheral micro foundations.

If I were trying to come up with a model of trading tomorrow, for example to address the correlation of prices with volume (my “Money as stock” left that hanging, and I’ve always wanted to come back to it), that’s what I’d do too.

At least, for positive purposes. We also have experience that models with different micro foundations can produce much the same positive predictions, but have wildly different welfare implications and policy conclusions. So I would be much more wary of policy conclusions from a model in which trading has nothing to do with information. So, though I love this paper’s answer (transactions taxes are highly damaging), and I tend to like models that produce this result, that is no more honest than most transactions tax thought, which is also an answer eternally in search of a question.

At this point, I should summarize the actual contributions of the paper. It’s really a great paper about risk sharing in incomplete markets, and less about volume. Though the micro foundations are a bit artificial, it very nicely gets at why volume factors seem to generate risk premiums. For that purpose, I agree, just why people trade so much is probably irrelevant. But, having blabbed so much about big picture, I’ll have to cut short the substance.

How will we really solve the volume puzzle, and related just what “liquidity” means? How does information make its way into markets via trading? With many PhD students in the audience, let me emphasize how deep and important this question is, and offer some wild speculations.

As in all science, new observations drive new theory. We’re learning a lot about how information gets incorporated in prices via trading. For example, Brian Weller and Shrihari Santosh show how pieces of information end up in prices through a string of intermediaries, just as vegetables make their way from farmer to your table — and with just as much objection from bien-pensant economists who have decried “profiteers” and “middlemen” for centuries.

Also, there is a lot of trading after a discrete piece of information hits the market symmetrically, such as a change in Federal Funds rate. Apparently it takes trading for people to figure out what the information means. I find this observation particularly interesting. It’s not just my signal and your signal.

And new theory demands new technique too, something that we learned from Bob. (Bob once confessed that learning the math behind dynamic programming had been really hard.)

What is this “information” anyway? Models specify a “signal” about liquidating dividends. But 99% of “information” trading is not about that at all. If you ask a high speed trader about signals about liquidating dividends, they will give you a blank stare. 99% of what they do is exactly inferring information from prices — not just the level of the price but its history, the history of quotes, volumes, and other data. This is the mechanism we need to understand.

Behind the no-trade theorem lies a classic view of information — there are 52 cards in the deck, you have three up and two down, I infer probabilities, and so forth. Omega, F, P. But when we think about information trading in asset markets, we don’t even know what the card deck is. Perhaps the ambiguity or robust control ideas Lars Hansen and Tom Sargent describe, or the descriptions of decision making under information overload that computer scientists study will hold the key. For a puzzle this big, and this intractable, I think we will end up needing new models of information itself. And then, hopefully, we will not have to throw out rationality, the implication that trading is all due to human folly, or the basic principles of finance such as preferences for money not securities.

Well, I think I’ve hit 4 of the 6 Bob Lucas deadly sins — big picture motivation, comments about about whole classes of theories, methodological musings, and wild speculation about future research. I’ll leave the last two — speculations about policy and politics, and the story of how one thought about the paper — for Andy and Fernando!

6 Aug 2020

A Better Choice - Barokong

Roll up your shirtsleeves, financial economists. As reported by Elizabeth Dexheimer at Bloomberg, Rep. Jeb Hensarling is “interested in working on a 2.0 version,”  of his financial choice act, the blueprint for reforming Dodd-Frank. “Advice and counsel is welcome."

The core of the choice act is simple. Large banks must fund themselves with more capital and less debt. It strives for a very simple measure of capital adequacy in place of complex Basel rules, by using a simple leverage ratio. And it has a clever carrot in place of the stick. Banks with enough capital are exempt from a swath of Dodd-Frank regulation.

Market based alternatives to a leverage ratio

The most important question, I think, is how, and whether, to improve on the leverage ratio with simple, transparent  measure of capital adequacy. Keep in mind, the purpose is not to determine a minimum capital level at which a bank is resolved, closed down, bailed out, etc. The purpose is a minimal capital ratio at which a bank is so systemically safe that it can be exempt from a lot of regulation.

The "right" answer remains, in my view, the pure one: 100% equity plus long term debt to fund risky investments, and short term liabilities entirely backed by treasuries or reserves (various essays here). But, though I still think it's eminently practical, it's not on the current agenda, and our task is to come up with something better than a leverage ratio for the time being.

Here are my thoughts. This post is an invitation to critique and improve.

Market values. First, we should use the market value of equity and other assets, not the book value. Risk weights are complicated and open to games, and no asset-by-asset system captures correlations between assets. Value at risk does, but people trust the correlations in those models even less than they trust risk weights. Accounting values pretend assets are worth more than they really are, except when accounting values force marks to market that are illiquid or "temporarily impaired."

Market values solve these problems neatly. If the assets are unfairly marked to market, equity analysts know that and assign a higher value to the equity. If assets are negatively correlated so the sum is worth more than the parts, equity analysts now that and assign a higher value to the equity.

Liabilities not assets. Second, we should use the ratios of liability values,  not ratios to asset values.   Rather than measure a ratio of equity to (accounting) asset values, look at the ratio of equity to the debt that the bank issues. Here, I would divide market value of equity by the face value of debt, and especially debt under one year. We want to know, can the bank pay off its creditors or will there be a run.

In principle, the value of assets = the value of liabilities so it shouldn't matter. Accountant and regulator assets are not the same as liabilities, which raises the important question -- if you want to measure asset values rather than (much simpler) liability values, then why are your asset values not the same as my liability values?

So far, then, I think the ratio of market value of equity to (equity + face value of debt) is both better and much simpler than the leverage ratio, book value of equity to complex book value of assets.

One can do better on ratios. (Equity + 1/2 market value of long-term unsecured debt ) / market value    of short term debt is attractive, as the main danger is a run on short-term debt.

Use option prices for tails. Market value of equity / face value of debt is, I think, an improvement on leverage ratios all around. But both measures have a common problem,  and I think we can do better.

A leverage (equity/assets) ratio doesn't distinguish between the riskiness of the assets. A bank facing a leverage constraint has an incentive to take on more risk. For example, you can buy a stock which costs $100, or a call option which costs $10, each having the same risk -- when the stock market moves 1%, each gains or loses $1 of value. But at a 10% leverage the stock needs $10 of capital and the call option only $1.

The main motivation of risk-weights is to try to measure assets' risk -- not the current value, but the chance of a big loss in value -- and make sure there is enough equity around for all but the worst risks. So let's try to do this with market prices.

A simple idea: So, you're worried that the same value of equity corresponds to a riskier portfolio? Fine: use option prices to measure the banks' riskiness. If bank A has bought stock worth $100, but bank B has 10 times riskier call options worth the same $100, then bank B's option prices will be much larger -- more precisely, the implied volatility of its options will be larger.

So, bottom line: Use the implied volatility of bank options to measure the riskiness of the bank's assets. As a very simple example, suppose a bank has $10 market value of equity, $90 market value of debt, and 25% implied volatility of equity. The 25% implied volatility of equity means 2.5% implied volatility of total assets, so (very roughly) the bank is four standard deviations away from wiping out its equity. Yes, this is a simplistic example, and the refinements are pretty obvious.

(For non-finance people: An option gives you the right to buy or sell a stock at a given price. The more volatile the stock, the more valuable the option. The right to sell for $80 a stock currently going at $100 is worth more, the more likely the stock is to fall below $80, i.e. the more volatile the stock. So option prices tell you the market's best guess of the chance that stocks can take a big fall.  You can recover from option prices the "implied volatility," a measure of the standard deviation of stock returns.)

We might be able to simplify even further. As a bank issues more equity and less debt, the equity gets safer and safer, and stock volatility goes down, and the implied volatility of options goes down. Perhaps it is enough to say "the implied volatility of your at the money options shall be no more than 10%."

Here's the prettiest rule I can think of. A put option is the right to sell stock at a given price. Assemble the minimum cost of put options that give the bank the right to issue stock sufficient to cover its short-term debt. For example, if the bank has $1,000 of short-term debt, then we could look at the value of 10 put options, each giving the bank the right to sell its stock at $100. If the market value of equity is greater than the cost of this set of put options, then the bank is ok.

(It would be better still if banks actually bought these put options, so they always had sitting there the right to issue equity in bad times. But then you might complain about liquidity and counterparty risk, so let's just use this as a measurement device.)

That's probably too fancy, but one should always start with the ideal before compromising. (Back to 100% equity.... )

In summary, I think we could improve a lot on the current leverage ratio by 1) using market values of equity 2) using ratios of liabilities, not accounting asset values at all and 3) using option prices to measure risk.

I left out the use of bond yields or credit default swaps to measure risk. The greater a chance of default, the higher interest rate that markets charge for debt, so one could in principle use that measure. It has been proposed as a trigger for contingent bonds or for regulatory intervention. I'm leery of it for lots of reasons. First, we're here to measure capital adequacy, so let's measure capital. Second, credit markets don't provide good measures of whether you're three or four standard deviations from default. Third, credit markets include not just the chance of default, but also the guess about recovery in default, and thus a guess about how big the bailout will be. But there is no reason in principle not to include bond information in the general picture -- so long as we can keep to the rule simple and transparent .

Our first step is to get our regulators to trust the basics: 1) stock markets provide good measures of total value -- at least better than regulators 2) option markets provide good measures of risk -- at least better than regulators.

Why not? I think our regulators and especially banks don't trust market values. They prefer the central-planning hubris that accountants and regulators can figure out what the market value and risk are better than the actual market.

If so, let's put this on the table in the open and discuss it. If the answer is "your proposal to use market value of equity and options is perfect in theory but we trust regulators to get values right a lot more than markets," then at least we have made 90% progress, and we can start examining the central question whether regulators and accountants do, in fact, outperform market measures. The question is not perfection or clairvoyance, it's whether markets or regulatory rules do a less bad job. Markets were way ahead of regulators in the last crisis.

What if market gyrations drive down the value of a bank's stock? Well, this is an important signal that bank management and regulators should take seriously by gum! Banks should have issued a lot more equity to start with to make sure this doesn't happen; banks should have issued cocos or bought put options if they think raising equity is hard. And when a bank's equity takes a tumble that is a great time to send the regulators in to see what happened. The choice act very nicely sets the equity ratio up as the point where we exempt banks from regulation, not a cliff where they get shut down.

Let's also remember, when you read the details, the leverage ratio is not all that simple or transparent either.Here is a good summary.

And let's also remember that perfection should not be the enemy of the much better. Current Basel style capital regulations are full of distorted incentives and gaming invitations. If there are small remaining imperfections, that

Or maybe not

Is fixing the leverage ratio all important?  What's wrong with a leverage ratio? Right now, banks have to issue capital if they take your money and hold reserves at the Fed or short term Treasury debt. That obviously doesn't make much sense as it is a completely riskless activity. More subtly, a leverage ratio forces banks to issue capital against activities that are almost as safe, such as repo lending secured by Treasuries.  Required reading on these points: Darrell Duffie Financial Regulatory Reform after the crisis: An Assessment

... the regulation known as the leverage ratio has caused a distortionary reduction in the incentives for banks to intermediate markets for safe assets, especially the government securities repo market, without apparent financial stability benefits....I will suggest adjustments to the leverage ratio rule that would improve the liquidity of government securities markets and other low-risk high-importance markets, without sacrificing financial stability.
The natural response is to start risk-weighting lite. The Bank of England recently exempted government securities from their leverage ratio.  The natural response to the response is, once we start making exceptions, the lobbyists swarm in for more. You can see in Duffie's writing that an exemption for repo lending collateralized by Treasuries will come next. Given the fraction of people who understand how that works, the case for resisting more exemptions will be weak.

The poster child for the ills of risk-weighted asset regulation: Greek sovereign debt still carries no risk weight in Europe. Basel here we come.

Interestingly, Duffie does not see banks currently shifting to riskier investing, the other major concern, though that may be because the Volker rule, Basel risk weights and other constraints also apply. So perhaps I should state the market-based measures not as alternatives to the leverage rule, but as measures to add to the leverage rule, in place of the other constraints on too much risk.

But how much damage is really done by asking capital for safe investments? Recall the Modigliani-Miller theorem after all. If a bank issues equity to fund riskfree investments, the equity is pretty darn risk free too, and carries a low cost of capital.  Yes, MM doesn't hold for banks, but that's in large part because of subsidies and guarantees for debt, and it's closer to true than to totally false -- the expected return on equity does depend on that equity's risk -- and the social MM theorem is a lot closer to holding and that's what matters for policy.

And even if funneling money to safe investments costs, say, an extra percent, does that really justify the whole Dodd-Frank mess?

In the end, it is not written in stone that large, systemic, too big to fail banks must provide intermediation to safe investments. A money market fund can take your deposits and turn them in to reserves, needing no equity at all. A bank could sponsor such a fund, run your deposits through that fund, and you'd never notice the difference until the moment the bank goes under... and your fund is intact.

Duffle again:

These resiliency reforms, particularly bank capital regulations, have caused some reduction in secondary market liquidity. While bid-ask spreads and most other standard liquidity metrics suggest that markets are about as liquid for small trades as they have been for a long time, liquidity is worse for block-sized trade demands. As a trade-off for significantly greater financial stability, this is a cost well worth bearing. Meanwhile, markets are continuing to slowly adapt to the reduction of balance sheet space being made available for market-making by bank-affiliated dealers. [my emphasis] Even more stringent minimum requirements for capital relative to risk-weighted assets would, in my view, offer additional net social benefits.

I emphasized the important sentence here. There are many other ways to funnel risk free money to risk free lending activities. The usual mistake in financial policy is to presume that the current big banks must always remain, and must always keep the same scope of their current activities -- and that new banks, or new institutions, cannot arise when profitable businesses like intermediation open up.

So, in the worst case that a liquidity ratio makes it too expensive for banks to funnel deposits to reserves, to fund market-making or repo lending, then all of those activities can move outside of big banks.

More Choice act

The Choice act has some additional very interesting characteristics.

Most of all, it offers a carrot instead of a stick: Banks with sufficient equity are exempt from a swath of regulation.

That carrot is very clever. We don't have to repeal and replace Dodd-Frank it its entirety, and we don't have to force the big banks to utterly restructure things overnight. Want to go on hugely leveraged? The regulators will be back in Monday morning. Would you rather be free to do things as you see fit and not spend all week filling out forms? Then stop whining, issue some equity or cut dividends for a while.

More deeply, it offers a path for new financial institutions to enter and compete. Compliance costs and a compliance department are not only a drag on existing businesses, they are a huge barrier to entry. Are markets illiquid? Are there people who can't get loans? The answer, usually forgotten in policy, is not to prod existing businesses but to allow new ones to enter. A new pathway -- lots of capital in return for less asset-risk regulation -- will allow that to happen.

Both politically and economically, it is much easier to let Dodd-Frank die on the vine than to uproot and replant it.

In the department of finish sanding, I would also suggest a good deal more than 10% equity.   I also would prefer a stairstep -- 10% buys exemption from x (maybe SIFI), 20% buys you exemption from y, and so forth, until at maybe 80% equity + long term debt you're not even a "bank" any more.

Remember, the issue is runs, not failure. Banks should fail, equity wiped out, and long-term debt becomes equity. The point of regulation is not to make sure banks are "safe" and "don't fail." The point of regulation is to stop runs and crises. So ratios that emphasize short term debt are the most important ones.

Duffle (above) also comes down on the side of more capital still. The "Minneapolis plan" spearheaded by Minneapolis Fed President Neel Kashkari (Speech,report by James Pethokoukis at AEI) envisions even more capital, up to 38%.


Anies Baswedan